First Quarter 2021 Write-Up
The equity markets performed well through the end of the first quarter 2021. The Dow Jones Industrial Average gained 7.8%, the Standard and Poor’s 500 Index added 5.8% and the Nasdaq Composite increased 2.8%. Positive stock performance was broad-based, in strong contrast with equity performance last year. Usually, market breadth is a good indicator of a healthy and robust stock market. The economy is certainly starting to run hot, aided by an unprecedented level of fiscal and monetary stimulus. However, we are also observing countervailing indicators that usually suggest a market top. High trading volumes, a receptive IPO market and rapidly expanding margin debt usually occur toward the end of a bull market, and we are seeing all of them today. Speculative trading also usually expands. We are seeing that in spades today. From the momentum-driven activity at GameStop (and the entire Wall Street Bets community phenomenon) to surging prices (and sometimes corrections) in cryptocurrencies and tokens (including Bitcoin, Dogecoin and non-fungible tokens), evidence of speculative trading is about as pronounced as we can recall. Additionally, market tops usually coincide with the uncovering of one or more examples of financial malfeasance or misfeasance on a massive scale. Greensill Capital, a supply-chain finance company forced into bankruptcy, and Archegos Capital Management, an over-leveraged family office that lost $20.0 billion in capital in two days, would be textbook examples. So, while some indicators seem discordant, one thing seems clear: as vaccinations continue and lockdown orders are relaxed, the economic recovery will heat up. As this happens, inflation expectations will come to the forefront of the investment process.
To be clear, inflation is coming. The only salient and arguable point is whether it is transitory or temporary. The economic numbers that will be reported for this month and next will face year-ago comparisons with an economy that was nearly paralyzed, so the variances will be dramatic. The Consumer Price Index (CPI) increased 1.7% in February and 2.6% in March, the biggest increase since 2009, another recession recovery year. May’s CPI will likely be in the 3-4% range. The second quarter, at least, should record inflation rates in excess of the Federal Reserve’s 2.0% long-term target. Actions and reactions by and between the federal government and the Federal Reserve in the next year will probably drive stock and bond market results. Let’s look at the recent actions of both.
Our government, irrespective of party control, seems addicted to issuing debt. Ten years ago, coming out of the Great Financial Crisis, the national debt stood at $14.0 trillion. Today, it stands at double that level, or $28.0 trillion. The first five Covid relief packages of 2020 amounted to about $4.0 trillion, or 18.7% of trailing GDP. The recently passed American Rescue Plan amounted to $1.9 trillion, or $13,260.00 per taxpayer. The proposed American Jobs Act will amount to an additional $2.2 trillion of spending, if passed. Republicans have proposed an alternative plan that will only amount to an additional $800 billion of spending, or $5,583.00 per taxpayer. We are generally horrified at the debt being incurred, nominally to stimulate an economy that is on the cusp of a full recovery.
Greg Ip, writing in his WSJ column Capital Account compared the Biden administration’s economic framework with the neoliberal economic framework embraced by Presidents Reagan, Clinton, Bush and Obama. He took the measure of “Bidenomics”:
If you studied, practiced or wrote about economic policy in the past few decades you probably absorbed certain rules about how the world worked: governments should avoid deficits, liberalize trade and trust in markets. Taxes and social programs shouldn’t discourage work…[This is neoliberalism.]
Growth: Old view: Scarcity is the default condition of economies: the demand for goods, services, labor and capital is limitless, their supply is limited. Over time the economy tends to operate at potential, i.e. full employment, so faster growth requires raising potential by increasing incentives to work and invest. Macroeconomic tools—monetary and fiscal policy—are only occasionally needed to deal with recessions and inflation.
Growth: New view: Slack is the default condition of economies. Growth is held back not by supply but chronic lack of demand, calling for continuously stimulative fiscal and monetary policy. J.W. Mason, an economics professor at John Jay College of Criminal Justice whose writing is a sort of handbook on post-neoliberal thought, explained on Twitter: The “economy doesn’t operate at potential on average, but is normally (at least in recent decades) somewhere well below it.” That suggests, he said, that “‘depression economics’ applies basically all of the time.”
Mr. Ip concedes that Bidenomics reflects the experience of the last twenty years when high debt and loose money saw low unemployment rates and negligible inflation. But he concludes that this type of big government spending can only survive when interest rates are near zero. This makes cooperation with the Federal Reserve an imperative.
In an April interview on CBS 60 Minutes, Federal Reserve Chair Jerome Powell appeared to confirm that cooperation, “What we're seeing now is really an economy that seems to be at an inflection point. And that's because of widespread vaccination and strong fiscal support, strong monetary policy support. We feel like we're at a place where the economy's about to start growing much more quickly and job creation coming in much more quickly.” Chairman Powell went on to suggest that it was “highly unlikely” that the Fed would raise rates in 2021. He closed the interview by saying, “I'm in a position to guarantee that the Fed will do everything we can to support the economy for as long as it takes to complete the recovery.” Well, OK then.
Or maybe not. We are advocates of an independent Federal Reserve. Outside political pressure on the Fed usually is bad for the Fed and the economy. The coming months might test the independence of the Federal Reserve. Over the last twelve months through March, the federal government ran a $4.1 trillion budget deficit. Over that same period, the Federal Reserve purchased $2.1 trillion of U.S. Treasury securities. The Fed financed 51% of government spending by creating dollars and buying securities. The Fed now holds over 25% of all marketable U.S. Treasury debt outstanding, up from less than 15% before the pandemic and less than 10% before the Great Recession. In the last twelve months ending in March, the Fed purchased 78% of the longer duration Treasury securities (i.e., notes and bonds) offered for sale, in attempt to manage interest rates. It is not hard to imagine that the Treasury depends very much on the Fed’s beneficence. If inflation accelerates above the 2% long-term target level, can the Fed ignore it because it thinks it is a transitory problem? Yes. How will the markets react to that? Probably not well. If the economy does overheat, and the Fed sees damaging inflationary pressures, how will it suppress it? Would it raise interest rates? Would it stop or curtail securities purchases? Would it do both? The optics might be worse than the options, but the options are not great. Our guess is that the Fed will put up with a lot more inflation than most expect today.
Back in 1977, Warren Buffett wrote an article called, “How Inflation Swindles the Equity Investor.” It was a very well-thought-out piece that systematically demonstrated how high rates of inflation (7% when written) and income and capital gains taxes can reduce expected economic returns for investors below zero, in some cases. He writes:
Most of those in political office, quite understandably, are firmly against inflation and firmly in favor of policies producing it. […] Discussions regarding future inflation rates usually probe the subtleties of monetary and fiscal policies. These are important variables in determining the outcome of any specific inflationary equation. But, at the source, peacetime inflation is a political problem, not an economic problem. Human behavior, not monetary behavior, is the key. And when very human politicians choose between the next election and the next generation, it’s clear what usually happens.
Very few investors today remember or appreciate the ravages of high inflation. The time to think about it is before it is upon us. We will have the tools to fight it, if we can summon the will. The debt issued to fight the pandemic will restrain economic growth over a long period, but over the next few quarters, the U.S. economy should come charging back. Hopefully the recovery will unlock America’s entrepreneurial strengths and let us rebuild our middle-class businesses.
Sincerely,
Your Team at Baxter Investment Management